What is Dollar Cost Averaging? Dollar Cost Averaging, or DCA, is a simple investment strategy in which an investor invests a fixed amount of money on a regular basis (e.g., each paycheck, monthly, quarterly, etc.) regardless of what the market is doing.
Dollar Cost Averaging Benefits
The most powerful and beneficial thing about Dollar Cost Averaging is that it gives investors, especially inexperienced ones, a plan to slowly build their investment portfolio on a regular basis with discipline. Let’s break it down.
- Start Investing with a Small Amount – Since the strategy doesn’t require a large sum of money, it enables investors to start sooner rather than later with just a small amount of money.
- Interval Investing – Secondly, it dictates that investors add money on a regular basis, usually monthly, which encourages good saving and investing habits.
- Discipline – Third, it encourages investing regardless of what the market is doing. In fact, DCA encourages investing during the down market because it helps you reduce the cost basis of investment.
This is basically the strategy used in my article How to Become a Millionaire by Investing $100 a Month.
Dollar Cost Averaging is not the most efficient strategy, but it is a great strategy for inexperience investors and works very well during down and volatile market.
When volatility comes to the stock market it is easy to let your emotions take hold of your actions. When you watch a lot of the ups and downs in the market, you can become scared and hold off on putting money into your investment and retirement accounts like you normally would.
In the end this can mean thousands of dollars less in your retirement nest egg. To help fight against your emotions you can use Dollar Cost Averaging through automatic investing to help bolster your retirement accounts in a volatile stock market.
How to Put Dollar Cost Averaging to Work
As discussed in How to Invest in the Stock Market, there are two simple ways to start putting Dollar Cost Averaging to work for you.
1. Contribute to Your 401(k) Plan
If your employer offers a 401(k) Plan, this is the perfect place to start. You just have to ask your HR or Plan Administrator to set up a deduction from your paycheck and choose how the money will be invested (for a beginner, just have all your contributions be invested in an S&P 500 Index Fund).
Every paycheck, a fixed dollar amount or a fixed percentage of your pay will be deducted from your check, deposited into your 401(k) Plan and invested in the fund(s) you chose.
2. Automatic Investment Plan
Another way to set up a DCA is to find a brokerage firm that offers Automatic Investment Plan. Basically, the investment account will withdraw money from a linked bank account and invest a fixed amount each month or each quarter into an investment that you choose. If you do this, make sure you find a broker that will not charge a fee each time you buy more shares and make sure the investments have low expense.
That said, I would not do this manually because if you have to pay a fee each time you trade, you’ll be losing too much money to transaction costs.
Dollar Cost Averaging versus Lump Sum Investing
What happens when you have a lump sum of money? For example, let’s say you got a $12,000 bonus from your job — should you invest $12,000 all at once (lump sum investing) or spread it out over 12 months by investing $1,000 a month?
The main fear when you invest all of your money in one transaction is you risk buying it at a higher price than if you trickled it in. Your target investment might have a spike in price that lasts several days or weeks just when you put your money in, only to have it fall back to a lower price level later. In this scenario you would be stuck with a higher cost in the investment than necessary.
Alternatively, you could spread your purchases across 12 months. By contributing on a consistent schedule you invest at times when the price is high, but also at times when the price is low. The end result is your get an average investment cost rather than risking everything on one transaction.
This sounds good in theory, but statistically, you’re better off investing in lump sum. Here’s why…
Based on a study by Vanguard, they concluded the following regarding systematic investment (i.e., Dollar Cost Averaging) vs immediate investment (i.e., Lump Sum)
History and theory support immediate investment.
On average, an immediate lump-sum investment has outperformed systematic implementation strategies across global markets. This conclusion is consistent with finance theory, as immediate investment exposes cash to (historically) upward-trending markets for a greater period of time.
Systematic implementation provides some protection against regret.
Systematic investment of a large sum can be thought of as a risk-reduction strategy. Such an approach can moderate the impact of an immediate market dip. Historically, however, the trade-off has been a lower return in the majority of market scenarios.
My own limited research also supports Vanguard’s finding. Here are two scenarios
DCA vs Lump Sum invested in VFINX in the 12 months
DCA vs Lump Sum invested in S&P 500 in 12 years
Even with a severe negative year in 2009, the lump sum approach still came out ahead!
|Date||S&P 500||Lump Sum||DCA|
Despite the fact that it can’t outperform Lump Sum investing, Dollar Cost Averaging is still an amazing strategy because:
- It helps ease fear for nervous investors and beginners — and we know the most important thing about investing is to get started as soon as possible, because nothing beats time in the market.
- It is a more realistic way to save and invest — most investors do not have a lump sum of money to invest all at once.
- It requires very little effort — for example, when you set up your 401(k) contributions or automatic investment plan, everything is automatic. Regular contributions require very little effort and help you build wealth.
- It works really well in down or volatile markets
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.